3) Class Three Chapter TWO How Mutual Funds Work (Mutual Fund Management)

Chapter 2
How Mutual Funds Work
Mutual Fund Management (GA31203)

Semester II, Session 2017/2018 Instructor: IFTEKHAR AMIN CHOWDHURY
FKAL, UMSKAL
Key Legislation
• Securities Act of 1933

– Regulates the sale of securities.
• Securities Exchange Act of 1934

– Regulates reporting by corporations.
– Established the SEC.
• Investment Company Act of 1940 (“the 1940 Act”)

– Regulates mutual funds.
• Investment Advisers Act of 1940

– Regulates some investment managers, including the managers of
mutual funds.

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Buying and Selling Fund Shares
Fund Issues Shares Investors
• Each fund is • The fund • Investors put

a separate issues shares their money
corporation, to the public into the fund
called a at net asset by buying
(registered) value (NAV). shares and
investment • Each share becoming
company. represents fund
proportional shareholders.
ownership of • Investors can
fund assets. sell their
shares back
to the fund at
NAV.

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Net Asset Value (NAV)
Assets Number of
Net Asset
minus shares
Value (NAV)
Liabilities outstanding
NAV is computed at the end of

every business day.
Investors may sell their shares
back to the fund (or redeem) at
the end of every business day.

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Buying and Selling Fund Shares
To ensure that funds have the ability to raise cash

quickly to pay redeeming shareholders, the 1940 Act
requires that funds:
– Limit borrowings.
– Limit holdings of illiquid securities.
In addition, most funds meet the 1940 Act tests for

diversification and:
– Limit holdings in a single security.
– Limit percentage ownership of the shares of a single
company.

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Pass-Through Tax Status
Fund Distributes Shareholder

Income
• Earns interest • Pays out a • Pays taxes

and dividend proportionate on
income from share of its distributions
investments. dividend and from the fund.
• May sell interest
investments income and
at a gain or net capital
loss. gains to each
• Pays no shareholder.
taxes if it
meets certain
tests.

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IRS Tests
To qualify for pass-through tax status, the IRS (Internal

Revenue Service) requires that funds:
– Limit holdings in a single security.*
– Limit percentage ownership of the shares of a single
company.*
– Distribute almost all income and net realized capital gains
annually.
– Earn most of their income from investing in securities and
currencies.
*IRS test is slightly different from similar 1940 Act test.

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A Virtual Corporation
Mutual funds generally don’t have employees.

– Instead, they hire other firms to provide needed services for
a fee.
– The fund signs contracts with these service providers.
Each fund has a board of directors which:

– Is elected by fund shareholders through a proxy vote.
– Negotiates contracts with service providers.
– Monitors potential conflicts of interest.
– Must have a majority of independent or disinterested
directors.

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The Management Contract
The most important contract is with the management

company which:
– Creates the fund.
– Lends its brand name to the fund family or fund complex.
– Serves as investment adviser and is responsible for
investment management of the fund’s portfolio.

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The Gartenberg Standard
A board’s review of the management contract is

governed by the Gartenberg standard. This legal
standard suggests that directors consider:
– The nature and quality of services provided.
– The profitability of the fund to the adviser.
– Any fallout benefits to the adviser (i.e., indirect profits).
– The extent of economies of scale as the fund grows.
– Fees charged on comparable funds.
– The independence and conscientiousness of the directors.
The Supreme Court recently reaffirmed the Gartenberg
standard in the Jones v. Harris case.

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Service Providers
The fund also signs contracts with firms that provide:
Links with • The distributor sells fund shares to the public.

• The transfer agent keeps track of shareholder
investors positions and provides customer service.
• The custodian holds the securities in the fund’s

Portfolio portfolio.
administration • The fund accountant maintains the fund’s books
and records and computes the NAV nightly.
Professional • Legal counsel.

services • Auditor.

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Service Provider Relationships
Some of these services are provided by firms affiliated

with the management company.
– Others are provided by independent firms.
Typical Service Provider Relationships

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Ethical Standards
Managers of mutual funds are fiduciaries.

– They must use their expertise to advance their clients’
interests and many not gain personally at their clients’
expense.
– They must present all material facts to their clients and
disclose any conflicts of interests.
Managers of mutual funds are registered investment

advisers.
– They must register with the SEC as required by the
Investment Advisers Act of 1940.
– The SEC requires that they have a written code of ethics.

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Components of a Registered Investment
Adviser’s Code of Ethics (1)
• General statement about expected

Standards of standard of business conduct.
• At minimum, must comply with all
business relevant laws and regulations.
conduct • May require avoiding appearance of
impropriety.
Protection of
material • To prevent insider trading.
nonpublic
information
FKAL, UMSKAL
Components of a Registered Investment
Adviser’s Code of Ethics (2)
Limits on • Apply to access persons with access to

information about the fund’s trading.
personal • Requires pre-clearance of personal trading.
securities trading • Prohibits certain trades.
Limits on gifts
• Usually applies to gifts both given and
and received.
entertainment
• Requires prompt reporting of violations.

Violations of the • The Chief Compliance Officer has
code responsibility for enforcing the code.

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Alternatives to Mutual Funds
Alternatives to mutual funds include:

– Direct ownership of securities.
– Other commingled investment vehicles.

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Direct Ownership of Securities
Options for direct ownership of securities include:

• Brokerage account
– Investor has high degree of control.
– Costs vary widely.
• Trust account
– For high net worth individuals.
– High customer service level.
• Separately managed account (SMA)

– Uses technology to adapt model portfolio selected by an investment
professional to an individual account.
– Can be customized to limited extent.

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Commingled Investment Vehicles (1)
• Open-end mutual funds

– Permit investors to redeem shares every day.
• Closed-end mutual funds

– Sell shares only once.
– List shares for trading on a stock exchange; price determined by
supply and demand.
– Do not redeem shares daily; instead, investors buy/sell on
exchange, often for less than NAV.
– Have declined in popularity.

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• Exchange-traded funds
– Shares listed for trading on a stock exchange; price determined by
supply and demand.
– Adjust the number of shares outstanding so that the market price
remains close to NAV.
– Are tax-efficient.
– Are growing in popularity.

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• Unit investment trusts

– Don’t hire an investment manager; a UIT buys a portfolio of
securities at creation, then holds it until the trust liquidates on a set
date.
– Investors can redeem shares at NAV, but they can also sell on the
open market or wait for trust to liquidate.
– Don’t have a board of directors.
– Are low-cost.
– Have declined in popularity.

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Commingled Investment Vehicles (4)S
• Hedge funds
– Aren’t required to register with the SEC, unlike the other
commingled vehicles discussed.
– Usually structured as limited partnerships.
– Limit investor ability to redeem.
– Use aggressive investing techniques and are not subject to
investment restrictions.
– Generally don’t have a board of directors.

FKAL, UMSKAL
Commingled Investment Vehicles
Feature Mutual Closed- Exchange- Unit Hedge
Fund End Fund Traded Investment Fund
(Open- Fund Trust
End)
Daily redemptions at X Open Open X No
NAV market market
sale sale
Pass-through tax X X X X X
status
Ongoing professional X X X No X
management
Supervision by X X X No No
independent
directors

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3) Class Three Chapter TWO How Mutual Funds Work (Mutual Fund Management)

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Chapter 2

How Mutual Funds Work

Mutual Fund Management (GA31203)

• Securities Act of 1933

• Securities Exchange Act of 1934

• Investment Company Act of 1940 (“the 1940 Act”)

• Investment Advisers Act of 1940

Mutual Fund Management (GA31203)

Fund Issues Shares Investors

• Each fund is • The fund • Investors put

Mutual Fund Management (GA31203)

NAV is computed at the end of

Mutual Fund Management (GA31203)

To ensure that funds have the ability to raise cash

In addition, most funds meet the 1940 Act tests for

Mutual Fund Management (GA31203)

Fund Distributes Shareholder

• Earns interest • Pays out a • Pays taxes

Mutual Fund Management (GA31203)

To qualify for pass-through tax status, the IRS (Internal

*IRS test is slightly different from similar 1940 Act test.

Mutual Fund Management (GA31203)

Mutual funds generally don’t have employees.

Each fund has a board of directors which:

Mutual Fund Management (GA31203)

The most important contract is with the management

Mutual Fund Management (GA31203)

A board’s review of the management contract is

Mutual Fund Management (GA31203)

The fund also signs contracts with firms that provide:

Links with • The distributor sells fund shares to the public.

• The custodian holds the securities in the fund’s

Professional • Legal counsel.

Mutual Fund Management (GA31203)

Some of these services are provided by firms affiliated

Typical Service Provider Relationships

Mutual Fund Management (GA31203)

Managers of mutual funds are fiduciaries.

Managers of mutual funds are registered investment

Mutual Fund Management (GA31203)

• General statement about expected

Limits on • Apply to access persons with access to

• Requires prompt reporting of violations.

Mutual Fund Management (GA31203)

Alternatives to mutual funds include:

Mutual Fund Management (GA31203)

Options for direct ownership of securities include:

• Separately managed account (SMA)

Mutual Fund Management (GA31203)

• Open-end mutual funds

• Closed-end mutual funds

Mutual Fund Management (GA31203)

Mutual Fund Management (GA31203)

• Unit investment trusts

Mutual Fund Management (GA31203)

Mutual Fund Management (GA31203)

Mutual Fund Management (GA31203)

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